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United States v. Matthew Martoma: Denial of Martoma’s Motion to Dismiss

In United States v. Martoma, 2013 WL 6632676 (S.D.N.Y. Dec. 17, 2013), defendant, Matthew Martoma (“Martoma”), was indicted in Count One for conspiracy to commit securities fraud and in Counts Two and Three for securities fraud. The United States District Court for the Southern District of New York denied Martoma’s motion to dismiss under Morrison v. National Australia Bank, holding that Rule 10b-5 applied to the transactions because they occurred in the United States. 

According to the allegations, Martoma employed an expert-networking firm to facilitate paid consultations with medical experts in the pharmaceutical industry. The firm expressly warned clients that the consultation dialogue should be limited to information already in the public domain. Between 2006 and 2008, Martoma allegedly used the network to form relationships with two doctors (“Doctor One” and “Doctor Two”) involved with clinical trials for a new Alzheimer’s drug being conducted on behalf of two pharmaceutical giants, Élan Corporation and Wyeth Pharmaceuticals, Inc.

During this period, Martoma allegedly organized and attended approximately 42 consultations with Doctor One, who served on the trial’s Safety Monitoring Committee (“SMC”). The indictment alleged that Doctor One gave Martoma confidential information relating to the safety of the new drug. Further, the indictment contended that Martoma obtained confidential information from Doctor Two as well. After receiving the confidential information, Martoma allegedly purchased both Élan and Wyeth stock and instructed his hedge fund employer to do the same.

In July 2009, Doctor One purportedly provided Martoma with additional information indicating that the Alzheimer’s drug was ineffective. Prior to informing the public of the drug’s inefficacy, the government asserted that Martoma caused his employer to sell “virtually all of its approximately $700 million worth” of holdings in Élan and Wyeth. The hedge fund also initiated various short sales and options strategies to profit from any decline in the company’s stock. These actions, according to the government, caused the fund to realize profits and avoid losses equal to $276 million. 

Rule 10b-5 prohibits “any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.” In Morrison v. National Australia Bank LTD., 561 U.S. 247 (2010), the Supreme Court concluded that Rule 10b-5 did not have extraterritorial effect.  For the provision to apply, the transaction at issue had to involve (1) the purchase or sale of a security listed on a US stock exchange, or (2) the purchase or sale of any other security that took place in the United States.

Martoma moved to dismiss Count Two and related parts of Count One, arguing that Section 10(b) did not apply because the subject transactions involved American Depository Receipts (“ADRs”) in Elan Corporation. The court found that the transaction met both tests under Morrison.  Although noting that ADRs could be characterized as “predominantly foreign securities transactions,” the Elan ADRs were listed on “an official American securities exchange.” 

In addition, the transactions occurred in the U.S. and not, as Martoma asserted, in Ireland.  Martoma focused on the fact that the actual shares were on deposit with the Bank of Ireland. The ADRs, in contrast, were “merely ‘receipts that may be redeemed for the foreign stock at any time,’” and, as a result, the “[t]he operative transaction for the issuance of Elan's ADRs— i.e., the deposit of Elan ordinary shares with The Bank of Ireland—was carried out in Ireland.”   

The court, however, disagreed.  Whatever the characterization of the ADRs, the focus of the analysis under Morrison was “where the transactions in the ADRs took place.”  Because the ADRs were listed on the NYSE, the relevant trade contracts, the passing of title, and the liability incurred by both parties to the transaction took place within the United States.

For the foregoing reasons, the court upheld the applicability of Rule 10b-5 to the present facts and denied Martoma’s motion to dismiss.  

The primary materials for this case may be found on the DU Corporate Governance website. 


SEC Proposes to Increase Access to Capital for Smaller Companies

On December 18, 2013, the SEC voted to propose new rules aimed at increasing access to capital for smaller companies. Press Release, Securities and Exchange Commission, SEC Proposes Rules to Increase Access to Capital for Smaller Companies (Dec. 18, 2013). Title IV of the Jumpstart Our Business Startup Act (“JOBS Act”) directed the SEC to propose this rule. Once the SEC proposal is published in the Federal Register, it will go through a 60-day comment period. 

Currently, when a company seeks to raise capital from potential investors by offering or selling securities, the Securities Act of 1933 requires registration with the SEC unless an exemption is otherwise available. Regulation A currently permits an exemption from registration for securities offerrings that do not exceed $5 million over any 12-month period, with a maximum of $1.5 million offered by security-holders of the company. While Regulation A requires companies to file with the SEC an offering circular that must comply with “requirements regarding form, content, and process,” small companies are not automatically required to file periodic reports once the offer is complete. Companies may also have to comply with state-level registration and qualification requirements.

Few companies have used the Regulation A exemption due to the cost and complexity of federal and state compliance. The JOBS Act included a provision that required the update and expansion of Regulation A. Specifically the SEC was directed to “adopt rules that would allow offerings of up to $50 million of securities within a 12-month period, require companies to file annual audited financial statements with the SEC, [and] adopt additional requirements and conditions that the Commission determines necessary.”

Labeled Regulation A+, the proposed changes would include two tiers of offerings. Tier 1 would be similar to the current Regulation A in that it covers offerings that do not exceed $5 million during any 12-month period, with a maximum of $1.5 million offered by security-holders of the company. 

Tier 2, on the other hand, would cover offerings that do not exceed $50 million during a 12-month period, with a maximum of $15 million offered by security-holders of the company. A company making an offering under $5 million would be able to choose to move forward under either Tier 1 or Tier 2. 

Under both tiers there would be basic requirements regarding issuer eligibility and disclosure. Tier 2 would have additional requirements, including limits on investor purchasing in relation to investor income or net worth, audited financial statements, and ongoing reporting and event updating. Tier 2 offerings would also be exempted from the requirements of state securities laws. The Regulation A+ exemption would only be available to companies who organize in and have their principal place of business in the U.S. or Canada. 

After the 60-days for public comment, the SEC will review the comments and make a determination on adopting the rule. 

The primary materials for this post may be found here.


Class Action Over $106 Million Merger Dismissed 

In Kugelman v. PVF Capital Corp., CASE NO. 1:13 CV 1606, 2013 BL 241456 (N.D. Ohio Sept. 9, 2013), the United States District Court for the Northern District of Ohio, Eastern Division, affirmed the dismissal of a class action suit brought against PVF Capital Corporation (“PVFC”), PVFC’s board of directors (“Directors”), and F.N.B. Corporation (“FNB”) (collectively, the “Defendants”) by an individual investor, Sylvia Kugelman (“Plaintiff”).

This securities fraud class action arose out of the proposed merger between PVFC and FNB. After several rounds of negotiations, FNB submitted an indication of interest to acquire the outstanding shares of PVFC in an all-stock transaction worth approximately $106 million. Plaintiff filed this lawsuit to prevent the merger.

Plaintiff alleged multiple claims for relief. First, Plaintiff asserted violations of Sections 14(a) and 20(a) of the Securities Exchange Act of 1934 (“Exchange Act”) arising from alleged misrepresentations and omissions in the proxy statement. Second, Plaintiff alleged that the Directors breached their fiduciary duties through materially inadequate disclosures and omissions in the proxy statement. Last, Plaintiff alleged the Directors breached their fiduciary duties of loyalty, good faith, and independence owed to the shareholders. 

Under the Private Securities Litigation Reform Act (“PSLRA”), a complaint must specify each statement alleged to have been misleading and the reasons why the statement is misleading. Further, an omission violates Section 14(a) of the Exchange Act only if an SEC regulation requires disclosure of the information or the omission makes other statements materially false or misleading. Here, Plaintiff’s complaint made no argument that the omitted material was required by the SEC. Rather, the complaint alleged the omitted material rendered other statements in the proxy statement misleading.

The court faulted the complaint for failing to “identify any specific statement” rendered misleading as a result of the omissions. Moreover, even with respect to broader sections of the Proxy, the court viewed the complaint as alleging that the omissions “are necessary to allow the shareholders . . . to assess the quality of the information provided in the Proxy Statement.” While recognizing that shareholders “might want more information,” shareholders were only entitled to information required by Rule 14a-9. The court found that Plaintiff failed to plead sufficient facts to show a plausible violation of Section 14(a).

Section 20(a) of the Exchange Act imposes joint and several liability on directors who control any person liable for securities fraud. Therefore, to violate Section 20(a), there must be a primary violation of federal securities laws. Given that Plaintiff’s Section 14(a) claim was dismissed, there was no primary violation on which a Section 20(a) claim could be premised.

The court declined to exercise jurisdiction over Plaintiff’s state law claims of fiduciary duty because the federal claims failed. 

The court granted Defendants’ motion to dismiss because Plaintiff failed to state a plausible claim for relief under the Exchange Act, and the court declined to exercise supplemental judgment over Plaintiff’s remaining state law claim. 

The primary materials for this case can be found on the DU Corporate Governance website.


Class Action Suit Against UGG Maker Over Security Fraud Dismissed

In Percoco v. Deckers Outdoor Corp., Civ. No. 12-1001-SLR. 2013 BL 180341 (D. Del. July 8, 2013), the United States District Court for the District of Delaware dismissed a class action lawsuit brought against UGG-maker Deckers Outdoor Corporation (“Deckers”); Deckers’ CEO, Angel Martinez (“Martinez”); and Deckers’ CFO, Thomas A. George (“George”) by an individual investor, Michael Percoco. 

Deckers, a Delaware corporation based in California, allegedly deceived investors about its financial outlook by failing to disclose adverse facts regarding its UGG brand. Despite a cost increase in the key component of UGG products, sheepskin, Deckers reported record results from October 2011 through April 2012. George was alleged to have stated that, through selective price increases and the addition of other footwear brands, Deckers would fully offset the negative impact on the bottom line. However, following an April 2012 press release announcing Deckers’ decreased gross margin of 46% and diluted earnings per share, Deckers stock dropped approximately 25% in one day. Percoco claimed violations of § 10(b) and § 20(a) of the Securities Exchange Act of 1934 (“Exchange Act”).

Shareholders filing a securities fraud lawsuit under § 10(b) of the Exchange Act are subject to heightened pleading standards. The Private Securities Litigation Reform Act (“PSLRA”) requires the plaintiff plead "with particularity": (1) each allegedly misleading statement and the reasons why the statement is misleading ("falsity"); and (2) the facts giving rise to a strong inference that the defendant acted with the required state of mind ("scienter"). In addition to those requirements, the PSLRA’s Safe Harbor Provision immunizes any forward-looking statement if it is accompanied by meaningful cautionary language.

The court determined that the allegations, if assumed true, met the falsity requirement. No program had been implemented to offset negative impact on the bottom-line. Further, Percoco had alleged that Deckers reported false numbers in its press releases.

However, the court found that Percoco’s pleadings failed to meet the scienter requirement. The close proximity of the allegedly false statements to the corrective disclosure was not enough. “Simply noting that only a short period of time existed between defendants' statements or omissions and the reporting of the apparent inconsistency is insufficient to find an inference of scienter.”

The court also declined to apply the “core operations” doctrine. The court found that at the time the statements were made it was conceivable that Deckers’ top executives would not have been able to accurately predict the price of sheepskin and how that would impact Deckers’ cost of goods sold. Further, a compelling scienter inference was not raised since the evidence showed that Martinez and George purchased shares of Deckers stock during the class period between October 2011 and April 2012.

Deckers provided numerous cautionary statements; however, Percoco alleged that Deckers knew its statements were false and that its forecasts were unattainable. The court concluded that Deckers was optimistic, but not unrealistic, and that the forward-looking statements were protected under the Safe Harbor Provision.

Section 20(a) of the Exchange Act imposes liability on contemporaneous traders for insider trading. Because this violation cannot be met without a § 10(b) violation, Percoco’s § 20(a) claim was dismissed.

The court granted Deckers’ motion to dismiss. Additionally, the court denied Percoco leave to further amend because Percoco did not offer any facts that could alter another court’s decision.

The primary materials for this case can be fount on the DU Corporate Governance website.


Conflict Minerals Rule Saga Continues

The saga of the SEC’s conflict minerals rule (“Rule”) continues with the SEC now presenting a very divided front on the issue.

On April 28 SEC Commissioners Gallagher and Piwowar issued a public joint statement in which they declared that the embattled Rule “should be stayed, and no further regulatory obligations should be imposed, pending the outcome of this litigation. Indeed, a stay should have been granted when the litigation commenced in 2012. A full stay is essential because the district court could (and, in our view, should) determine that the entire rule is invalid.”

The conflict minerals rule has been the subject of great controversy and discussion but was largely upheld by the recent decision by the DC Circuit Court. The two Commissioners argue that that decision wrongly found that the First Amendment prohibited only the Rule’s requirement that issuers identify any products that have not been determined to be DRC conflict free. They note that simply re-working that requirement would not alleviate an issuer’s obligation to conduct due diligence on their supply chain and to describe those efforts in its conflict minerals report and suggest that this forces an issuer to admit to having “blood on its hands” for its products since it is sourcing certain minerals from the DRC.

They argue further that the “name and shame” approach that is at the heart of the Rule and of Section 1502 of the Dodd-Frank Act itself is flawed because only the naming of the products is sufficient to achieve the intended benefits. Therefore, they suggest “disclosures about the due diligence process should not be seen as severable from the unconstitutional scarlet letter of not DRC conflict free.”

At heart, the two Commissioners favor invalidation not only of the conflict minerals rule but a Congressional reconsideration of Section 1502. Absent such a reconsideration of course, the SEC has no option but to try and redraft the Rule in a way that will pass constitutional muster because Section 1502 requires the SEC to implement that Section’s directives. To that point the Commissioners argue that reconsideration of the Section itself is appropriate because the Section fails to achieve the benefits it was intended to and unnecessarily imposes great costs on issuers:

Unfortunately, the evidence is that it has been profoundly counterproductive, resulting in a de facto embargo on Congolese tin, tantalum, tungsten, and gold, thereby impoverishing approximately a million legitimate miners who cannot sell their products up the supply chain to U.S. companies. Reconsidering Section 1502’s core approach would also save investors billions of dollars in compliance costs, and ease the problem of information overload by eliminating special interest disclosures that are immaterial to investment decisions.

Therefore they say, a “full stay of the effective and compliance dates of the conflict minerals rule would not fix the damage this rule has already caused, but it would at least stanch some of the bleeding.”

Perhaps in response, and certainly in contradiction, on April 29 SEC Chairman Mary Jo White told members of the House Financial Services Committee that the agency will continue to implement the Rule and that the SEC staff will release guidance by the end of April on what public companies will be required to report under parts of the rule that the court upheld.

Guidance would be helpful as the first conflict minerals report that was filed was confusing at best and non-compliant at worst. That said, the final outcome of the reporting requirement remains uncertain. It is of course impossible to know what the DC District Court will do with the Rule. It may or may not agree with Commissioners Gallagher and Piwowar. There are certainly many who do not agree with them that the Rule has not achieved the results it intended to achieve. Sasha Lezhnev of the Enough Project suggests just the opposite. All we know for sure right now is that the saga continues.


American Petroleum Institute v. SEC: D.C. District Court Vacates SEC Rule Mandating Public Disclosure of Payments to Foreign Governments that Pertain to Natural Resources

In Am. Petroleum Inst. v. S.E.C., CIV.A. 12-1668 JDB, 2013 WL 3307114 (D.D.C. July 2, 2013), the United States District Court for the District of Columbia granted plaintiffs’ motion to vacate a Securities and Exchange Commission (“Commission”) rule requiring certain companies to publicly disclose information pertaining to payments made to foreign governments in connection with the commercial development of various natural resources.

In adopting Dodd-Frank, Congress sought to address corruption and wasteful spending in resource rich countries. 156 Cong. Rec. S3801-02, 2010 WL 1956763. To do so, the Act added Section 13(q) to the Securities Exchange Act of 1934. 15 U.S.C.A. § 78m (West). To implement the requirement, the Commission promulgated Rule 13q-1. The Rule required disclosure of natural resource related payments to foreign governments on new “Form SD.”

Plaintiffs challenged the rule, arguing among other things, that the Commission’s reading of the statute to require public disclosure of reports was erroneous and that declining to create an exemption for countries prohibiting disclosure was arbitrary and capricious.

The Commission contended that it was without discretion under the statute to reach another result. The SEC asserted that disclosure was required to be in an annual report and the report was required to be “public.”  Specifically subsection (2)(A) of Section 13(q) provided that “the Commission shall issue final rules that require each resource extraction issuer to include in an annual report . . . information relating to any payment made [to a government for] the commercial development of oil, natural gas, or minerals.” Further, Section 13(q)(3) provides that “to the extent practicable, the Commission shall make available online, to the public, a compilation of the information required to be submitted under . . . paragraph (2)(A).”

The court, however, disagreed. “To state the obvious, the word ‘public’ appears nowhere in this provision. The statute speaks of ‘disclosure’ and ‘an annual report,’ not ‘public disclosure’ and not a ‘publicly filed annual report.’"

The Commission also argued that Congress intended for the information to be made public because “the Exchange Act is fundamentally a public disclosure statute,” which required public disclosure of annual reports. The court rejected this argument for three reasons. First, Section 13(q) differed from an Exchange Act provision in that it was not aimed to protect investors. Second, textual presumptions were  not dispositive when a statutory provision explicitly addressed the issue. Third, provisions of the Exchange Act sometimes only required “reports” to be disclosed to the Commission. For these reasons, the court held that the fundamentals of the Exchange Act did not necessarily require public disclosure of such payment information.

The Commission’s remaining argument rested on its interpretation of the word “compilation.” The Commission contended that “compilation of the information” unambiguously meant consolidating all independent reports. However, the Supreme Court had previously established that a compilation was “something composed of materials collected and assembled from various sources or other documents” and ordinary usage of the word also illustrates that a compilation could encompass selective materials. Thus, the Commission’s argument for mandatory public disclosure of the annual report failed.

Lastly, the court found that the Commission’s denial of any exemption for countries that prohibited such disclosures was arbitrary and capricious. The Commission had declined to adopt any exemptions because doing so would be “inconsistent with Section 13(q),” and “would undermine Congress’ intent to promote international transparency efforts.”  The court, however, disagreed. The Commission's view of the statute's purpose — international transparency at all costs, exemptive authority or not — thus contradicts what section 13(q) says on the very question.” With respect to other reasons for denying the exemption, the court noted that “where an agency ‘has relied on multiple rationales (and has not done so in the alternative), and [a court] conclude[s] that at least one of the rationales is deficient, [the court] will ordinarily vacate the [action] unless [it is] certain that [the agency] would have adopted it even absent the flawed rationale.’ "

Consequently, the court granted the plaintiffs’ motion for summary judgment, vacated the Rule, and remanded to the Commission for further consideration.

The primary materials for this case may be found on the DU Corporate Governance website.


First Conflict Minerals Report Filed

Ahead of the June 2 deadline (technically May 31 but moved to the June 2 as May 31 is a Saturday) the first required filing under the conflict minerals rule was made on Thursday April 24 by Taiwan-based Siliconware Precision Industries Co., Ltd.

The filing is interesting in many ways. First, it is a bit surprising that a report came in so early in view of the recent DC Circuit opinion striking down portions of the rule. (discussed here and  here). We expected issuers to wait for guidance about how to make proper disclosures that would comport with both the rule and the ruling striking down the requirement to disclose if an issuer’s products have “not been found to be ‘DRC conflict-free.’ ”

Siliconware (“SPIL”) in its report stated that it:


  • undertook due diligence to determine the conflict minerals status of the necessary conflict minerals used in its semiconductor packaging services. In conducting its due diligence, SPIL implemented the OECD Due Diligence Guidance for Responsible Supply Chains of Minerals from Conflict-Affected and High-Risk Areas (OECD 2011) ("OECD Framework"), an internationally recognized due diligence framework.


SPIL has determined in good faith that for calendar year 2013, its conflict minerals status resulting from its due diligence efforts shows a portion to be "DRC conflict undeterminable" and the remainder to be "DRC conflict free" (terms as defined in the 1934 Act).

The designation of some products to be “DRC conflict undeterminable” is not unexpected. The rule gives large issuers a two year period in which they may use this designation rather than being forced to state that minerals are not conflict free. It is widely expected that many issuers will rely on this provision to gain time to improve their supply chain diligence.

What is more interesting is the inclusion of the “DRC conflict free” label. SPIL in its report states that some of its products are conflict-free but did not conduct an independent private sector analysis (“IPSA”). This appears to be in direct violation of Question 15 of the SEC’s Question and Answer on Conflict Minerals which states:

(15) Question:

If an issuer does not obtain an IPSA of its Conflict Minerals Report because one of its products is “DRC conflict undeterminable,” may it describe any of its other products as “DRC conflict free” in its Conflict Minerals Report?


No.  An issuer is not required, under the rule, to describe any qualifying products as “DRC conflict free” in its Conflict Minerals Report. The Commission stated in the adopting release, however, that an issuer may choose in its Conflict Minerals Report to describe its products with conflict minerals sourced from the DRC or its adjoining countries as “DRC conflict free” if the issuer is able to determine that the conflict minerals in those products did not finance or benefit armed groups in that region based on its due diligence. The rule defines due diligence as including an IPSA of the Conflict Minerals Report. Therefore, to be able to describe qualifying products in its Conflict Minerals Report as “DRC conflict free,” an issuer must have obtained an IPSA. 

The eagerness of SPIL to use the conflict-free designation lends support to the view that many issuers will leap to use this designation even though the rule cannot compel them to do so. We fully expect other issuers, such as Intel and Apple, who have touted their conflict-free status to proudly proclaim it in in their filings. On the other side of the equation, no issuer will state that their products are not conflict-free as there is no legal requirement--at present--to do so. 

This raises fascinating issues about the mandatory/voluntary nature of disclosure. Would issuers have moved to disclose their conflict free status absent the rule? Who knows? Public awareness of the situation in the DRC has been growing and investors have been pushing for disclosure for some time. But we will never know for sure. What we do know is that a flawed rule may well produce the results that many were hoping for.


In re Longwei Petroleum: Red Flags Save 10(b) and 20(a) Claims from Dismissal

The United States District Court for the Southern District of New York partially granted a motion to dismiss claims under sections 10(b) and 20(a) of the Securities Exchange Act against Longwei Petroleum Investment Holding Ltd.’s (“Longwei”) directors and auditors. In re Longwei Petroleum Investment Holding Ltd., 13 CV 214 (HB), 2014 BL 20751 (S.D.N.Y. Jan. 27, 2013).

Shareholder plaintiffs (“Plaintiffs”) brought a class action against Longwei Petroleum and its directors and auditors (“Defendants”) for securities fraud. Plaintiffs alleged that Longwei’s directors—Michael Toups, Douglas Cole, and Gerald DeCiccio (“Directors”)— were liable for misrepresentations on Longwei’s financial filings and for false statements made in a 2011 press release. Plaintiffs alleged that Longwei’s auditors, Child VanWagoner & Bradshaw, PLLC and Anderson Bradshaw, issued unqualified audit reports about Longwei’s financial position and its conformity with generally accepted accounting principles.

Defendants filed a motion to dismiss for failure to state a claim challenging the elements of misrepresentation, scienter, and loss causation in Plaintiffs’ section 10(b) claim.

With respect to the claims of misrepresentation, Directors asserted that any misstatements were either not attributable to them or constituted puffery. The misstatements in question were company financial filings signed by defendant Directors and filed with the SEC. The filings allegedly showed revenues totaling hundreds of millions of dollars while financial reports issued to Chinese authorities showed revenues in only the hundreds of thousands. Plaintiffs presented additional evidence including interviews, photos of abandoned rail tracks connecting to Longwei’s facilities, and a failed safety inspection, to demonstrate that Longwei could not have generated the revenues reported in the SEC filings and had most likely not operated the plants in question for quite some time. The court deemed these allegations sufficient to show misrepresentation.

Defendants also challenged whether the Plaintiffs had adequately pleaded scienter. Plaintiffs alleged scienter through conscious misbehavior or recklessness. The court found that the pleadings sufficiently alleged that CFO Michael Toups had regular access to Longwei’s financial information and should have been aware of the alleged fraud, which would have been “obvious to even a casual observer.” It also found that, as alleged in the complaint, Directors Cole and DeCiccio, members of Longwei’s audit committee, failed to take any action with respect to admitted financial reporting failures. Additional red flags, such as Longwei’s inadequate reporting and remarkable revenues compared to its competitors, the court reasoned, should have put the Directors on notice to the strong possibility of fraud.

The court further found sufficient allegations of scienter to survive a motion to dismiss with respect to Longwei’s Auditors. The allegations were sufficient to show that the auditors should have been aware of the red flags but that they were disregarded. Additionally, the pleadings sufficiently demonstrated loss causation by alleging that the disparity in Longwei’s actual revenues versus its reported revenues caused Plaintiffs’ losses.

Regarding the 20(a) claim, the court found that through adequately pleading scienter, Plaintiffs also sufficiently alleged culpability for directors Toups, Cole, and DeCiccio. The complaint asserted that the directors each had responsibility for overseeing Longwei’s financial and audit reports and each signed the company’s Form 10-K statements. Conversely, the court found that Plaintiffs did not allege sufficient facts to demonstrate that Longwei’s auditors knew of or consciously participated in the fraud.

Therefore, the court granted the motion to dismiss the section 20(a) claim against the auditors and denied all other motions to dismiss.

The primary materials for this case may be found on the DU Corporate Governance website.


CSR—and other-- Disclosure as “Compelled Speech”: The US and the EU Consider Very Different Approaches

The fate of compelled commercial speech is the subject of great uncertainty in the US at the moment given two recent decisions by the U.S. Court of Appeals for the D.C. Circuit.  As many previous posts have discussed,  (herehere, here, and here) ,the conflict minerals rules issued by the SEC was subject to many legal challenges, including one based on the First Amendment.  It its decision of April 14th the Court of Appeals upheld many aspects of the conflicts minerals rule but struck down the requirement that issuers must disclose if it cannot determine that its products are “DRC conflict free.”   Under the rule, that disclosure must be made in the issuer’s filing with the SEC and made to the public on the company’s website.   In striking down this provision of the rule the Court of Appeals agreed with the National Association of Manufacturers that such a disclosure was not factual, but ideological in nature, and that it was not targeted at preventing consumer deception.

The critical issue in the First Amendment portion of the case turned on the appropriate level of review.  The U.S. Supreme Court held in Zauderer v. Office of Disciplinary Counsel that government can constitutionally require disclosures of a “purely factual” nature which are “reasonably related to the State’s interest in preventing deception of consumers.” The Court has repeatedly reaffirmed Zauderer, most recently in the 2010 case Milavetz, Gallop & Milavetz, P.A. v. U.S., where Justice Sotomayor wrote for a unanimous Court that a low level of scrutiny applies only in cases where the compelled speech is “directed at misleading commercial speech.”  Because the “conflict free” labeling requirement went beyond that, the rule was subject to heightened scrutiny of Central Hudson.

At the same time as issuing the opinion, the Clerk of the D.C. Circuit issued an order staying the mandate in NAM v. SEC until seven days after disposition of a request for rehearing or rehearing en banc. This means that the court’s decision has not yet taken legal effect. Because NAM’s Administrative Procedures Act challenge failed, it is possible that both parties could seek rehearing.  Each party has 45 days in which to file a rehearing petition.  So far, neither has.

As noted by the dissenting opinion in NAM v. SEC, another case currently pending the same circuit, American Meat Institute v. U.S. Dep’t of Agriculture, raises comparable issues.   In that case the AMI argued that Department of Agriculture rules requiring country of origin labeling compelled speech in violation of the First Amendment because the rules were not aimed at preventing the deception of consumers.   A three judge panel of the Court of Appeals found that Zauderer encompassed interests beyond preventing customer confusion and upheld law.  Thereafter the D.C. Circuit vacated the panel decision and ordered en banc review.  Oral argument is set for May j19th.  

The outcome of these cases will have significant impact on many types of disclosures including but not limited to labeling regarding genetically modified organisms, child labor practices and many others.

At the same time that is seems likely that at least the DC Circuit is willing to uphold some First Amendment challenges to compelled commercial speech, the European Union is taking steps in the opposite direction.  On April 15th the European Parliament adopted  the Directive on disclosure of non-financial and diversity information to require large companies and groups to disclose information on policies, risks and results as regards environmental matters, social and employee-related aspects, respect for human rights, anti-corruption and bribery issues, and diversity on boards of directors.

The new rules will only apply to large companies with more than 500 employees and should impact approximately 6 000 large companies and groups across the EU. Companies will be required to disclose “information necessary for an understanding of their development, performance, position and impact of their activity, rather than a fully-fledged and detailed report. Furthermore, disclosures may be provided at group level, rather than by each individual affiliate within a group.”  Under the Directive, companies may choose how best to make their disclosures and may use international, European or national guidelines which they consider appropriate (for instance, the UN Global Compact, ISO 26000, or the German Sustainability Code).

Large listed companies will be required to provide information on their board diversity policy, including, but not limited to, age, gender, educational and professional background. Disclosures will set out the objectives of the policy, how it has been implemented, and the results. Companies which do not have a diversity policy will have to explain why not.

In order to become law, the Commission's proposal needs to be adopted jointly by the European Parliament and by the EU Member States in the Council (Following today's adoption by the European Parliament, the Council is expected to formally adopt the proposal in the coming weeks.  Thereafter the EU member states will have two years to implement the requirements in their national legislation.  Each member state may grant exemptions from the reporting requirements.  Already efforts are underway in some member states to protest the legislation, notably in Germany where the BDI trade association for German businesses argues that the legislation is unnecessary, because more and more firms are already producing reports on corporate social responsibility (CSR) without being forced into it.  "In recent years, the number of companies in Germany who publish annual sustainability or CSR reports on a purely voluntary basis has steadily increased," said Holger Losch, a member of the BDI's executive board.

Thus the European Union may soon be a far cry away from the US position on compelled commercial speech—at least if American Meat Institute goes the way of the NAM v. SEC.  Even if American Meat is more nuanced it seems hard to imagine US disclosure regulations reaching as far as those proposed under the EU Directive especially given the statement in the NAM v SEC opinion that “Congress [could] not require issuers to disclose the labor conditions of their factories abroad or the political ideologies of their board members, as part of their annual reports? Those examples, obviously repugnant to the First Amendment, should not face relaxed review just because Congress used the “securities” label.

Much uncertainty remains in each of the US and EU as to the ultimate outcome of the divergent approaches to non-financial disclosure regulation.  The varying approaches will provide interesting opportunities for empirical comparisons—even as they lead to frustration for issuers.


City of Brockton Ret. Sys. v. CVS Caremark Corp: Court Finds Adequate Pleadings by Brockton Upon Remand

Upon remand from the First Circuit Court of Appeals, the District Court of Rhode Island in City of Brockton Ret. Sys. v. CVS Caremark Corp., 09-cv-554-JL, 2013 WL 6841927 (D.R.I. Dec. 31, 2013), denied CVS Caremark Corporation’s (“CVS”) motions to dismiss the claims submitted by a class of CVS shareholders (“Plaintiffs”). With all of the judges in the District Court of Rhode Island recused, the matter was set before Judge Joseph N. Laplante of the District Court of New Hampshire.

Plaintiffs asserted a claim under Section 10(b) of the Securities Exchange Act of 1934, alleging that they purchased CVS securities after relying on purportedly fraudulent statements made by CVS following its merger with Caremark Rx, Inc. (“Caremark”) in 2007. According to Plaintiffs, the company misrepresented the success of the integration of the two companies. When the market learned of the turth, share prices allegedly declined by 20%.    

Defendants sought dismissal alleging that Plaintiffs had not sufficiently asserted actionable misstatements or omissions or adequately plead scienter.   

To establish a claim under Section 10(b), the complaint must specify the statement that was misleading, the reasons why it was misleading, and if relied upon, it must state with particularity facts that would support reliance on such statements. However, Plaintiffs were not required to plead evidence, but “only to put ‘a significant amount of meat . . . on the bones of the complaint.’ ”  In order to satisfy the scienter requirement, the complaint must show either “conscious intent to defraud or a high degree of recklessness.” Under corresponding Rule 10b-5 “a complaint must ‘state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind’ to sustain the claim.”

The court found that plaintiffs sufficiently alleged misrepresenations. The court focused on allegations that CVS had denied that it "had lowered prices for some of its PBM customers 'because of a lack of service' ." The Plaintiffs, however, asserted that CVS had in fact “unilaterally reduced prices on over 50 percent of its existing PBM contracts in order to retain customers that were dissatisfied with [its] inferior service [and] integration-related issues.” Reiterating that Plaintiffs did not have to plead evidence but only to put some "meat . . . on the bones of the complaint," the court found that the failure to allege any specific contract that had been re-priced in response to a perceived lack of service was not "fatal" to the claim.   

The court also rejected allegations that the statements alleged to be false constituted “inactionable puffery.” The court agreed that defendants were “probably right” that a number of the alleged misstatements qualifed. Nonetheless, for purposes of the motion, dismissal would not be warranted where at least one statement did not meet the definition. The court declined to find as puffery the statement alleging that the repricing of the prescription benefit manager business was not a result of a “lack of service.”

With respect to scienter, the court noted that CVS’s CEO was directly confronted with a question about whether the price cuts had any connection to concerns about service. In response, according to plaintiffs, the CEO denied that it did and instead stated that the repricing was done on "accounts that we kind of wanted to lock down." 

The court found the allegations sufficient to allege scienter.

  • Asked point-blank, then, whether “a concern about service” among the company's PBM customers had caused it to lower its prices, [the CEO] unequivocally denied that, and proffered an alternative explanation that cast no aspersions on any aspect of the CVS–Caremark integration. If, as the plaintiffs allege, that statement was indeed untrue—and, again, taking a cue from the Court of Appeals, this court rules that the plaintiffs have sufficiently alleged as much—then the statement, by its very nature, supports a “cogent and compelling” inference that the CEO was acting either with the intent to deceive or with a high degree of recklessness as to whether he was doing so.

The court found that Plaintiffs “adequately pled at least one actionable misstatement,” and that scienter had been adequately pled for that statement. The Court of Appeals had also initially found loss causation to be adequately pled. Consequently, CVS’s motion to dismiss was denied.

The primary materials for this case may be found on the DU Corporate Governance website.


The Evolution of Executive Compensation and the Impact of Say on Pay

The NYT published a pair of pieces on executive compensation. One looked at the amount (a 9% increase in the median) and the other looked at the metrics used to determine the amount. Other articles have suggested that companies use a wide variety of metrics that rely on "unconventional earnings measures." 

The analysis of the amounts was nothing new. Compensation routinely climbs in good and bad years (although 2008 was an exception). With a 26.5% increase in stock prices last year, it was a surprise only that compensation grew by a more modest 9% (of course average wage increases for other workers was around 3%).

What is new, is that the analysis takes place in a "say on pay" era when compensation is given a more public examination. Shareholders have generally pushed for compensation to be determined on the basis of clear standards based primarily on performance. The new era, therefore, provides an opportunity to assess whether "say on pay" has wrought any significant changes to compensation.    

The articles demonstrate a few things that were predictable but are now apparent. Experience in other countries indicated that "say on pay" would not put downward pressure on the amount of compensation, but instead would affect the method of calculation. That has occurred. It is clear that for the most part companies base compensation on performance metrics, with total shareholder return and earnings per share commonly employed. The emphasis on performance has not, as the 9% median increase illustrates, put downward pressure on total amount.

One effect, however, may have been the compression of total compensation. The NYT articles indicated that the most highly paid CEO in 2013 was at Oracle. Oracle used a non-GAAP method to assess performance and has been subjected to a negative say on pay vote two years running. Thus, while it is at the top of the list, the compensation package is viewed with considerable disfavor by shareholders.  

The second highest (and this is only for CEOs in companies that had filed proxy statements in time for the study) was Bob Iger at Disney, with a total compensation at $34.3 million. Here is where it gets interesting. If you go back to 2007, during the pre-say on pay era, the highest paid CEO made more than the Oracle CEO. Moreover, the top 10 highest paid CEOs included eight individuals who received total compensation of more than $40 million. For a list, go here.  

So say on pay may, therefore, be reducing the number of outliers and compressing compensation. Most likely the amounts are more consistent with a company's peer group. In any event, it seems clear that boards are less likely to have their CEO compensation stick out in a way that makes it an example of corporate excess. Problems with compensation remain and the median amounts are climbing, but a significant reduction in the number of extreme outliers is nonetheless a beneficial change wrought by say on pay.   


Anonymous Whistleblower Awarded $14 Million by the SEC

On October 1, 2013, the SEC awarded more than $14 million to an anonymous whistleblower whose information led to an enforcement action that recovered substantial investor funds. This was the largest award granted since the whistleblower program was established in 2011.

Congress authorized the whistleblower program through the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) to provide monetary incentives to individuals who  voluntarily provide high-quality original information that results in an SEC enforcement action with sanctions exceeding $1 million. Information is voluntary if it is reported prior to the SEC or a regulatory agency requesting it. To be original, the information must be derived from the whistleblower’s independent knowledge or analysis and must be new information to the SEC. The information leads to a successful action if it opens a new investigation or reopens a closed investigation, and the SEC brings a successful enforcement action based on the information provided. By law, the SEC must protect the whistleblower’s confidentiality.

The whistleblower awards do not reduce amounts paid to harmed investors because payments are made through a separate fund established by the Dodd-Frank Act. Awards can range from 10 to 30 percent of the money collected in the case. Additionally, the program prohibits retaliation by employers against employees who report information. The SEC hopes these awards will encourage those with information to come forward. 

Until this matter, awards have been modest in amount. The first whistleblower award under the Dodd-Frank Act was made in August 2012 for $50,000. 

In August and September of 2013, over $25,000 was awarded to three whistleblowers who helped halt a sham hedge fund, and the award will likely exceed $125,000 once all payments are made.

Most recently, on April 4, 2014, the SEC announced an additional $150,000 payment to the recipient of the first whistleblower award.  

The October award was the first multi-million dollar payment awarded under the program.

In this case, the whistleblower voluntarily provided original information that led to a successful enforcement of Section 21F(b)(1) of the Securities Exchange Act of 1934and Rule 21F-3(a) thereunder.

The SEC Claims Review Staff considered the factors set forth in Rule 21F-6 in relation to the facts and circumstances of the whistleblower’s application. They determined that the award appropriately recognized the significance of the information reported, the assistance the whistleblower provided, and the law enforcement interest in deterring violations. Less than six months after the anonymous whistleblower’s tip, the SEC was able to bring an enforcement action and secure investor funds. The tip allowed the SEC to investigate an enforcement matter more quickly than would have otherwise been possible.

The primary materials for this post can be found on the DU Corporate Governance website.


Wagner v. Royal Bank of Scotland: Court Denies Motion to Dismiss Claim for Alleged 16(b) Violations

In Wagner v. Royal Bank of Scotland Grp. PLC, the United States District Court for the Southern District of New York denied a motion to dismiss Jeff Wagner's (the "Plaintiff") claim to recover short-swing profits generated by defendants, Royal Bank of Scotland Group PLC and its conglomerates (collectively, “Defendants”), through swap agreements that led to transactions in LyondellBasell Industries, N.V. (“LBI”) securities, of which Plaintiff was a shareholder. No. 12 Civ. 8726 (PAC), 2013 BL 239950 (S.D.N.Y. Sept. 5, 2013). In denying the Defendants’ motion to dismiss, the court recognized the Plaintiff’s complaint pursuant to Section 16(b) of the Securities Exchange Act of 1934 (“Section 16(b)”).    

Since its formation in 2009, LBI maintained two classes of ordinary outstanding shares that were structured to automatically convert to a single class of ordinary outstanding shares upon a triggering event. On December 6, 2010, LBI’s Class B shares were converted into Class A shares according to this provision.

During October 2010, the Defendants and various counterparties entered swap agreements that related to specified baskets of equities. LBI’s Class B shares were the primary focus of several of these swap agreements. Between October 2010 and December 2010, the Defendants maintained beneficial ownership of more than 10% of LBI’s outstanding Class A shares.   

Plaintiff alleged that because the Defendants controlled the equity baskets subject to the swap agreements, the addition of approximately 358,000 LBI Class B shares to the equity baskets between October and November 2010 was equivalent to purchasing the same quantity of Class B shares, which, in turn, was equivalent to purchasing Class A shares, a potential Section 16(b) violation. 

The legislative intent of Section 16(b) was to prevent inside parties from “engaging in speculative transactions on the basis of information not available to others.” Section 16(b) imposes a strict-liability standard on insiders who procure short-swing profits on transactions made within a six-month period of time. Under Section 16(b), a plaintiff must prove that an issuer’s officers, directors, or principal shareholders purchased and sold its securities within a six-month period.

To support their motion to dismiss, Defendants first argued that the swap transactions at issue were exempt from Section 16(b) because the Defendants’ pecuniary interest in LBI securities was never affected by the swap transactions. Defendants emphasized that the swap transactions merely altered the nature of their beneficial ownership in the underlying securities. The court declined to address this issue because, in considering a motion to dismiss, a court must only assess the plausibility of facts alleged in the complaint and is not required to assess the factual validity.

Defendants also argued that the transactions were not based on any type of inside information that would trigger liability under Section 16(b). The court denied the validity of this argument based on precedent reemphasizing the strict liability standard imposed by Section 16(b), indicating that “such a blunt instrument was the only way to control insider trading.”

Finally, Defendants pointed to certain administrative decisions that ostensibly precluded similar transactions from Section 16(b) liability due to a lack of pecuniary interest in subject securities. The court, however, emphasized that the administrative decisions referenced were narrowly construed and expressly stated that “any different facts or conditions might require a different conclusion.” More importantly, the court pointed out that Defendants explicitly admitted to having a pecuniary interest in the LBI securities.

For the foregoing reasons, the court denied the Defendants’ motion to dismiss.

The primary materials for this case may be found on the DU Corporate Governance website.  


Bank of America, Kenneth Lewis and the Financial Crisis

Bank of America settled a case with the Attorney General of NY, Eric Schneiderman over the acquisition of Merrill Lynch. The settlement included a $10 payment by Kenneth Lewis, the former CEO of BofA. A copy of the settlement is here. The case was heralded as a major victory. According to Schneiderman:
  • “Today’s settlement demonstrates a major victory in our continued commitment to applying the law equally to individuals, as well as corporations. I would hope this closes one chapter of our ongoing efforts to ensure the frauds that occurred in and around the financial crisis are not forgotten.” 

Perhaps this is the end of the matter. We take the moment though to say, one last time, that whatever the merits of the disclosure claim, the closing of the acquisition of Merrill by BofA probably saved the financial system from going into terminal meltdown. An earlier post is here.  

With Lehman having failed and the banks not lending, who knows what the shock of a Merrill failure would have had on the teetering financial system. Ken Lewis was head of the bank at the time of the acquisition. For those with a memory of these things, his decision to go through with the acquisition when there were legal grounds to walk away probably saved this country from descending into an even deeper and more brutal recession. Thus, Mr. Lewis should be, as his lawyer described, "proud of the role he played in helping the U.S. banking system survive. . ."


The SEC's Disclosure Project

On Friday, April 11, the Director of the Division of Corporation Finance gave a speech that provided a "path" forward on the division's corporate disclosure reform project. Replacing "disclosure overload" with "disclosure effectiveness," the speech noted that the object was not just to focus on the "costs and burdens" but to determine "whether there is information that is not part of our current requirements but that ought to be." Reducing disclosure, while apparently a goal, was not "the sole end game."   
The Division intends to start the review with "the business and financial disclosures that flow into periodic and current reports, namely Forms 10-K, 10-Q and 8-K, and, in one way or another, make their way into transactional filings." Proxy disclosure will be included in "a later phase." Specifically, the Division sought comments on:
  • Whether there is information that we require companies to include in their filings that those investors routinely get elsewhere. Is there information that they routinely ignore? What information do they think is missing? And in the age of smartphones and tablets, how can information be easier to access and use? And do technological advances lend themselves to a 'one-size-fits-all' approach, or should companies have flexibility to determine how they can convey information more effectively?

In addition, the guidance specifically stated that "our disclosure requirements might benefit from a broader principles-based approach, similar to our current rules for MD&A." Efforts would be made to improve navigability, including the use of structured data, hyperlinks, or topical indexes.

The approach in the speech promises to seek effective disclosure. With that as a goal, it seems as if the staff will need to seriously consider tagging all of the SEC forms under review. Doing so will allow the information to be easily accessible through the use of software and other tools. The SEC's Investor Advisory Committee has widely supported tagging but specifically recommended the tagging of some items in the Form 8-K. In addition, a tagging taxonomy has already been developed for the MD&A

The decision to focus on periodic reports mostly eliminates one of the arguments for disclosure reduction. While cost to the issuer is always available as a basis for reducing disclosure, readability and access by ordinary investors is not. For the most part, periodic reports are technical filings not designed, as the proxy statement should be, for readability. The documents are likely accessed mostly by market professionals. 

As Professor Coffee recently testified: "I do not believe it is realistic to expect Form 10-Ks to become short and concise. Indeed, securities analysts want them that way because they see them as a treasure trove of valuable data. Form 10-Ks are not aimed at the retail investor, but at the professional: the securities analyst and other intermediaries." Shareholders may want a shorter annual report (as in a Rule 14a-3 annual report), but there is no evidence that they are seeking a shorter Form 10-K.

As for principles based disclosure "similar" to MD&A, the MD&A and its history does not provide a propitious role model, the staff will have to seriously weigh whether it will be effective in practice. MD&A has not been a great success with respect to meaningful disclosure. As the staff of the Commission has noted: MD&A produces "too much meaningless 'boilderplate' . . .  that provides . . . no meaningful information."  

In the late 1980s and early 1990s, the Commission staff devoted an enormous amount of time and resources to improving MD&A. See MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, Exchange Act Release No.  26831 (May 18, 1989); see also, IN THE MATTER OF CATERPILLAR INC., Exchange Act Release No. 30532 (admin proc March 31, 1992) (first SEC case brought for violation of MD&A without also including claim under antifraud provisions). As the boilerplate quote indicates, however, the efforts didn't work and were eventually abandoned.

If the staff seeks to mimic the MD&A approach, it will have to explain how the approach will result in higher quality of disclosure than MD&A. As the efforts back in the 1980s/1990s show, the staff has limited time and resources to police principles based disclosure. Thus, whatever promise the approach has in theory, the practice could easily be a disclosure system more reliant on boilerplate. Boilerplate will accomplish the goal of reducing issuer expense but at the cost of a reduction in disclosure effectiveness.   


Partial Victory For the SEC on its Conflict Minerals Rule (Part 2)

So far things are going swimmingly for the SEC; however, once the Court reached the First Amendment argument it sang a different tune. 

The Association challenged the Rule’s requirement that an issuer describe its products as not “DRC conflict free” in the report it must file with Commission and on its website, claiming that it unconstitutionally compels speech. The Court of Appeals agreed. It refused to apply rational basis review, noting that such a standard of review is “the exception, not the rule, in First Amendment cases. See Turner Broad. Sys., Inc. v. FCC, 512 U.S. 622, 641-42 (1994). The Court recognized that the Supreme Court has applied rational basis review to disclosures of “purely factual and uncontroversial information.” Zauderer v. Office of Disciplinary Counsel, but held that the designation of non-conflict free status required under the Rule did not qualify for this treatment. Specifically, the Court of Appeals asserted:

  • At all events, it is far from clear that the description at issue—whether a product is “conflict free”—is factual and non-ideological. Products and minerals do not fight conflicts. The label “conflict free” is a metaphor that conveys moral responsibility for the Congo war. It requires an issuer to tell consumers that its products are ethically tainted, even if they only indirectly finance armed groups. An issuer, including an issuer who condemns the atrocities of the Congo war in the strongest terms, may disagree with that assessment of its moral responsibility. And it may convey that “message” through “silence.” See Hurley, 515 U.S. at 573. By compelling an issuer to confess blood on its hands, the statute interferes with that exercise. 

The Court also noted that Zauderer is limited to cases in which disclosure requirements are "reasonably related to the State’s interest in preventing deception of consumers" and pointed out that “[n]o party has suggested that the conflict minerals rule is related to preventing consumer deception. In the district court the Commission admitted that it was not.”’

The Court of Appeals also refused to use the ruling in SEC v. Wall Street Publishing Institute, Inc, to justify upholding the Rule under the First Amendment.  In Wall Street Publishing the court held that the Commission could, without running afoul of the First Amendment, seek an injunction requiring that a magazine disclose the consideration it received in exchange for stock recommendations, using a “less exacting level of scrutiny," even though the injunction did not fall within any well-established exceptions to strict scrutiny.  Significantly, the court noted:

  • To read Wall Street Publishing broadly would allow Congress to easily regulate otherwise protected speech using the guise of securities laws. Why, for example, could Congress not require issuers to disclose the labor conditions of their factories abroad or the political ideologies of their board members, as part of their annual reports? Those examples, obviously repugnant to the First Amendment, should not face relaxed review just because Congress used the “securities” label. 

Having rejected rational basis as the standard of review, the Court concluded that the Rule could not pass muster under even the intermediate review standard set forth in Central Hudson. Under Central Hudson:

  • the government must show (1) a substantial government interest that is; (2) directly and materially advanced by the restriction; and (3) that the restriction is narrowly tailored. 447 U.S. at 564-66; see R.J.Reynolds, 696 F.3d at 445. The narrow tailoring requirement invalidates regulations for which “narrower restrictions on expression would serve [the government’s] interest as well.” Cent. Hudson, 447 U.S. at 565. Although the government need not choose the “least restrictive means” of achieving its goals, there must be a “reasonable” “fit” between means and ends. Bd.of Trs. v. Fox, 492 U.S. 469, 480 (1989). The government cannot satisfy that standard if it presents no evidence that less restrictive means would fail. Sable Commc’ns v. FCC, 492 U.S.115, 128-32 (1989).

The Court found that the SEC had provided no evidence that less restrictive means than those called for by the Rule would fail and therefore held that the Rule, and the statute, violate the First Amendment to the extent they require regulated entities to report to the Commission and to state on their website that any of their products have “not been found to be ‘DRC conflict free.’ ”

A dissenting opinion joined in all but the First Amendment portions of the majority. The dissent did not address specifically the merits of the First Amendment claim but noted that a “question of central significance to the resolution of that claim is pending before the en banc court in another case.”  He therefore argued that the Court should “hold in abeyance our consideration of the First Amendment issue in this case pending the en banc court’s decision in the other, rather than issue an opinion that might effectively be undercut by the en banc court in relatively short order.”

The case referred to by the dissent is American Meat Institute v. United States Department of Agriculture, No. 13-5281. In that case, a panel of the Court of Appeals found that labeling requirements for meat products were valid under Zauderer’s standard requiring that disclosure mandates be “reasonably related” to the government’s interests. Significantly, that decision rejected the suggestion that Zauderer review applies only to disclosure mandates aimed to cure consumer deception. The fate of that decision is unclear, however, because the full Court of Appeals will rehear the case en banc on May 19, 2014. In the rehearing the Court will “receive supplemental briefing on the question whether review of “mandatory disclosure” obligations can “properly proceed under Zauderer” even if they serve interests “other than preventing deception.”  Because the majority opinion rests on the premise that Zauderer applies only to the prevention of deception, the dissent would have preferred to withhold a decision on the First Amendment claim here pending the en banc decision in American Meat Institute

So what does this mean for issuers subject to the Rule? The first filings under the Rule are due May 31 (actually June 2 as May 31 is a Saturday). 

Issuers are still obligated to determine if they are subject to the rule, to conduct a reasonable country of origin test if they are so subject, and to conduct due diligence on their supply chain and must file a conflict minerals report if it believes its conflict minerals may have originated in covered countries. What is now unclear is what, exactly, the report will have to say when labeling the conflict minerals. If the majority opinion is not reheard (or consolidated with American Meat, it seems likely that the SEC will have to act to change the “not been found to be DRC conflict-free” requirement struck down by the Court. How quickly they will do this and what they will put in its place remains to be seen. As of the end of day on April 14 an SEC spokeswoman said the agency was still reviewing the Court's decision. 

In addition to those issuers directly impacted by this decision, it should be of great interest to those who argue for broader SEC disclosure for matters pertaining to political, social, and human rights issues. The statement in the majority opinion that a Congressional mandate requiring issuers to disclose the labor conditions of their factories abroad or the political ideologies of their board members, as part of their annual reports would be “obviously repugnant to the First Amendment” sounds a note of caution to those hoping to use the conflict minerals rule as a template for broader disclosure matters.


Diversity, the Board of Directors, and the Role of Women

As we have long discussed on this Blog, corporate boards are not diverse. In 2013, approximately 14% of directors were women and/or minorities. In the S&P 500, the average number of women on a board is two (although approximately 9% have no women). In the S&P 1500, the average is one.

The usual explanation for this is the dearth of qualified candidates. The idea that, among executives, professors, lawyers, politicians, non-profits, etc. there are not enough qualified women and minorities is inaccurate. Over time, however, the argument becomes harder to make with a straight face. This can be seen with particular clarity in connection with educational trends.

Recent figures put out by the Bureau of Labor Statistics shows a growing educational divide between men and women. As the Bureau provides: "By 27 years of age, 32 percent of women had received a bachelor's degree, compared with 24 percent of men." Of course, there are not likely to be very many 27 year olds on the board (although Chelsea Clinton was elected to a board of a public company at 31). Nonetheless, the statistics suggest that boards lacking in meaningful diversity are not projecting a particularly progressive image to what is increasingly the most educated segment of the U.S. population. 


WM High Yield Fund v. O’Hanlon: Court grants Motion for Summary Judgment dismissing securities fraud claims, including claims under scheme liability

In WM High Yield Fund v. O’Hanlon, No. 04-3423, 2013 BL 172104 (E.D. Pa. June 23, 2013), the United States District Court for the Eastern District of Pennsylvania granted a Motion for Summary Judgment for failure to provide evidence of deceptive conduct or investor reliance under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”).

According to the allegations, Defendant Matthew Colasanti (“Colasanti”) was an internal consultant who managed the loan workout group for Diagnostic Ventures, Inc. (“DVI”), a financial services firm operating in twenty countries. Plaintiffs are six institutional funds that invested in DVI debt securities through the New York Stock Exchange from August 10, 1999 to August 13, 2003. On August 13, 2003, DVI filed for Chapter 11 bankruptcy protection, DVI was subsequently delisted, and the debt securities lost substantially all of their value.  

The DVI loan workout group was responsible for recovering on delinquent loans made by the company. Colasanti, among others at DVI, approved accruals of income on delinquent loans for the DVI financial statements. Colasanti was not a member of DVI’s Board of Directors, did not otherwise participate in any of DVI’s accounting or financial reporting, and did not sign any of DVI’s public filings.

Plaintiffs’ complaint averred that Colasanti, in conjunction with other DVI officers and directors, intentionally deceived investors by overstating DVI’s earnings to artificially inflate the market price of DVI securities in violation of Section 10(b) of the Exchange Act and Rule 10b-5. Section 10(b) prohibits “any manipulative or deceptive device” in connection with the purchase or sale of a security. Rule 10b-5(b) specifically prohibits misleading statements. Subsections (c) and (a) make it unlawful to employ any “scheme” to defraud or engage in any conduct which operates as fraud. The Court had previously found that the complaint contained no averments of any misleading statements and therefore dismissed claims against Colasanti under Subsection (b) but left open the possibility of scheme liability under Subsections (a) and (c).

Plaintiffs alleged that Colasanti engaged in “actionable conduct.”  The Court, however, found that the allegations were insufficient to establish reliance, one of the elements of Rule 10b-5.  The allegedly deceptive conduct had not been specifically attributed to Colasanti.  As the Court noted:  “The record does not establish that the Plaintiff Funds knew about or otherwise relied on anything said or done by Colasanti at the time that they purchased or sold DVI’s securities.”   

Plaintiffs further contended that Colasanti owed a duty to disseminate accurate information about the company’s financial condition. An affirmative duty arises when there has been a misleading prior disclosure. However, Plaintiffs never pled an affirmative duty to disclose on the part of Colasanti. The Court commented that absent a duty to disclose, silence is not misleading under Rule 10b-5.

Because the record failed to provide triable disputes as to deceptive conduct or reliance on the alleged conduct by the Plaintiffs, the Defendant’s Motion for Summary Judgment was granted.

The primary materials for this post may be found on the DU Corporate Governance website.


Gender Equality and Insider Trading

Insider trading can occur where someone violates a duty of trust and confidence. In the corporate world, these duties are often set out in an express confidentiality agreement. The duties can, however, be explicit.

The duty can also arise in other circumstances. Anyone with a duty of trust and confidence may be guilty of insider trading if they trade on material non-public information in violation of that duty. A psychiatrist who learns something from a patient or a lawyer who receives details from a client both qualify. 

Even more interestingly the duty can also arise in the context of family relationships. Sometimes information is conveyed to a family member with an expectation that it will be kept confidential and not used as a basis for trading activity. Needless to say, family members typically do not sign confidentiality agreements with each other so the obligation is implicit rather than explicit. 

A duty of trust and confidence often is said to exist between a husband and wife. Moreover, with more women reaching important positions in the corporate world, it is increasingly likely that they will be the source of the material nonpublic information. This was in fact the case in two recent actions brought by the SEC

In both, one spouse allegedly "overheard" the business conversations of the other and used the acquired information to profit in the stock market. In each instance, it was the wife who held the relevant corporate position and the husband who traded on the information. In one case, the wife was a finance manager; in the other she was the senior tax director.

The release noted that this case, as well as others, involving a husband allegedly trading on material nonpublic information obtained from his spouse:

  • The SEC has brought other insider trading cases involving individuals who traded on material, nonpublic information misappropriated from spouses. For example, last year the SEC charged a Houston man with insider trading ahead of a corporate acquisition based on confidential details that he gleaned from his wife, a partner at a large law firm that was consulted on the deal. In 2011, the SEC charged an Illinois man who bought the stock of an acquisition target of a company where his wife was an executive despite her requests that he keep the merger information confidential. In a different 2011 case, the SEC charged the spouse of a CEO with insider trading on confidential information that he misappropriated from her in advance of company news announcements.

As gender roles evolve husbands have increased their role in the housework and the child rearing function. They have also, apparently, increased their risk of insider trading.   


Shareholder Proposals and the Merits of the UK Model

The shareholder proposal rule has come under assault.  The rule permits shareholders owning $2000 of a company's stock to submit a proposal that must be included in the proxy statement (unless a ground for exclusion is available).  A recent editorialin the WSJ called for changes that would reduce the number of proposals.  The letter from CII and also published in the WSJ was a through rebuttal of the  arguments made in the editorial.  As the letter noted:

  • More than 85% of the companies in the Russell 3000 didn't receive a single shareholder proposal in 2013. What's more, the costs to companies that Mr. Knight cites are largely self-inflicted. Too many companies choose to spend tens of thousands of dollars—shareholders' money—in legal fees in an effort to keep these proposals from coming to vote. Some companies even up the ante by going straight to court to block shareholder proposals, bypassing the Securities and Exchange Commission's well-established, less costly process for reviewing these submissions.

We want to take issue with one additional argument in the editorial.  The editorial noted that other countries had higher threshholds for shareholder access to the proxy statement.

  • Shareholders of U.K.-registered companies face a more reasonable test: They must be supported by at least 5% of eligible voting shareholders to submit a proposal, or represent a group of at least 100 shareholders whose collective stake is valued at a minimum of £10,000, or approximately $16,660.

The statement is true but it omits more than it includes.  First, Section 338 of the Companies Act in the UK allows 100 members owning at least £100 to submit a proposal as long as they "have a right to vote on the resolution at the general meeting."  In other words, there is no one year holding period.  See Rule 14a-8(b) ("In order to be eligible to submit a proposal, you must have continuously held at least $2,000 in market value, or 1%, of the company's securities entitled to be voted on the proposal at the meeting for at least one year by the date you submit the proposal.").

Second, Section 338 does not limit shareholders to 500 words.

Third and most important, Section 338 specifies the grounds for omission of a proposal.  There are exactly three.  As the statute provides, a resolution may properly be moved at an annual general meeting unless:

  • (a) it would, if passed, be ineffective (whether by reason of inconsistency with any enactment or the company’s constitution or otherwise), (b) it is defamatory of any person, or (c) it is frivolous or vexatious.

Thats it.  Compare this to Rule 14a-8 and the 13 vague and unpredictable grounds for exclusion. 

Moreover, these grounds are used routinely by the staff of the Commission to exclude the vast majority of proposals that are submitted for consideration.  Thus, in 2012 the staff agreed to allow for the exclusion of 75% of the proposals challenged (196 excluded of the 263 considered), a number that did not include the 47 that were withdrawn. In 2013, the percentage was 66% (173 excluded of the 263 considered), with 68 withdrawn. 

Lest one think this is because shareholders are poor drafters.  Think again.  At least some of them are from what can be characterized as debatable interpretations of the exclusions in the Rule.  For example, in 2013, the staff reiterated that a proposal was vague and therefore subject to exclusion because it referred to the NYSE definition of director independence.  See Chevron (March 2013). The staff considered it "vague" to use a definition that it or something close to it is employed by all listed companies (Nasdaq has a substantially identical definition) and easily accessible. 

Or how about the exclusion of a letter that was designed to specifically meet the standards set out in an earlier staff letter?  The new resolution was close but, apparently, just missed the mark.  See Bank of America, Feb. 19, 2014 ("In this regard, as we have previously stated, we believe that the incentive compensation paid by a major financial institution to its personnel who are in a position to cause the institution to take inappropriate risks that could lead to a material financial loss to the institution is a significant policy issue. However, the proposal relates to the compensation paid to any employee who has the ability to expose Bank ofAmerica to possible material losses without regard to whether the employee receives incentive compensation and therefore does not, in our view, focus on the significant policy issue.").

Had these proposals been submitted in the UK, they almost  certainly would have been included. So the editorial does get one thing rights.  Adopting the British model would prevent the diversion of "substantial company resources and ultimately SEC resources."  This is because, unlike the model in the US, there would be almost no grounds for excluding a proposal.  Companies would presumably no longer challenge proposals and the SEC would largely be out of the review business.  This would save expenses for everyone including investors and taxpayers.    

Want to read more on the need to reduce the SEC's role in reviewing shareholder proposals, see Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.    

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